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November 3, 2010

The Implications of Fed QE2 for Client Portfolios

Wednesday’s announcement that the Fed will be buying hundreds of billions of dollars in U.S. Treasury securities is anything but a surprise. Fed Chairman Ben Bernanke initially mentioned the idea back in early August and has been discussing it publicly ever since.

The program, known as quantitative easing (or QE2, because this is the second round of easing since the crash of 2008), has two objectives, both of which are intended to boost the sputtering U.S. economic recovery. First, buying long-dated Treasuries in large quantities decreases long-term interest rates by artificially raising prices and reducing yields. Second, the program increases liquidity in the financial system because the money that the Fed spends buying the securities will be transferred directly to private institutions that can turn around and lend it back into the economy.

There are three main implications of QE2.

1) The Near-Term Implications

Regardless of how you feel about the merits of the policy—it’s a bold, complex plan with plenty of supporters as well as detractors—it’s important to understand its near-term implications for your clients’ portfolios. Predicting future interest rates is impossible, of course, but given the scope of this policy it’s reasonable to expect that the yield curve will stay near or below its current level for at least a little while longer.

But for investors looking to put new capital to work in fixed income in the near-term, QE2 won’t make it any easier. The policy is explicitly designed to keep rates low so that borrowers can obtain credit cheaply, so finding bonds with attractive yields will require some effort. (Note that the BondDesk monthly Market Transparency Report provides a detailed snapshot of corporate yields you can use to help identify opportunities in the market.)

2) The Past Implications

It is also worthwhile to understand the impact that QE2 has already had on your clients’ portfolios, almost a full three months before it went into effect. The initial announcement by Mr. Bernanke immediately triggered a massive Treasury rally at the long end of the curve. Yields on the 10-year while 30-year bonds fell precipitously in August and (except for a couple of bullish weeks in early September) continued to drift down until mid-October.

But for reasons that aren’t completely clear, things changed in mid-October. Notably, 30-year rates increased substantially, closing above 4.0% for the first time since before the August announcement. The yields on 10-years also increased, though not quite as dramatically. One explanation is that institutional investors decided that yields had overcorrected in anticipation of QE2, so they sold their positions before rates turned around.

Alternately, the smattering of positive economic news in October may have driven investors out of Treasuries and into riskier asset classes. Still another reason could be concerns about inflation. Regardless, the present yield curve is now historically steep.

The falling rates of the past 2.5 months (excluding late October) have had predictable results on investor demand. Trade volumes of individual bonds have essentially been decreasing in lockstep with yields since August. The trends are similar whether we look at corporate trading volumes from TRACE or our own Treasury volumes from the BondDesk trading platform.

Meanwhile, fund performance has gotten a nice boost from the falling yields and fund inflows remain near historic highs.

Interestingly, the retail market seemed to appreciate the rise in rates during the second half of October. On the BondDesk platform, Treasury buying activity on Oct. 25, for example, was nearly double the volume earlier in the month.

3) The Long-Term Implications

The longer-term implications of the policy are much harder to predict. One fact everyone agrees on is that QE2

substantially increases the money supply in the U.S. because the Fed is essentially printing new cash to buy these bonds.

Some economists feel this policy will trigger substantial inflation down the road (possibly sooner than later), creating problems for fixed-income investors who hold low-yielding securities. Others say that current deflation is our biggest concern, so boosting the money supply to force inflation deliberately is the right thing to do.

Whatever the case, QE2 is a bold move by Bernanke and the Fed that will impact the investing landscape for years to come.

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